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Payroll Taxes on Children
By Jason Watson, CPA
Posted Sunday, July 11, 2021
Children do not pay any Social Security or Medicare taxes until they reach 18 years of age if he or she-
- works for a parent who owns a sole proprietorship or partnership (recall that a multi-member LLC is taxed as a partnership),
- works in domestic service (babysitting, chauffeurs, etc.), or
- delivers newspapers (the law really lists newspapers.. who does this anymore?)
However, with an S Corp election this blows up because the child is now working for a corporation, and not the parent. In other words, when you run your business as a sole proprietor, you and the business are one in the same. Same thing with a single-member LLC and a partnership. But an LLC with an S corporation election now becomes a corporation for taxation purposes, and your child loses this exception.
For example, your sole proprietorship or LLC could pay your child $12,000. He or she would not pay payroll taxes (Social Security and Medicare), and neither would you as the employer. Your child could then gift the take-home money back to you and your spouse. It is presumed that his or her tax rate would be lower than yours, and therefore you created some tax arbitrage. There is not a kiddie-tax issue since this is earned income. Furthermore, depending on how fruitful you are or your religion, you might have a hefty amount of salaries being paid to your gaggle of children bypassing a lot of payroll taxes.
Yes, he or she would have to file a tax return. But you would still claim the exemption as a dependent. No, having babies is not good tax advice. Kids are expensive. Really expensive.
There are creative types out there who will set up a single-member LLC which is solely owned by the Mom or Dad. Then, this LLC charges a consulting fee to the S Corp and then pays out the proceeds as salary to the children. In theory this bypasses payroll taxes (Social Security and Medicare) since it is an LLC that is paying the salary rather than the S corporation. This is sometimes referred to as a Family Management LLC.
We do not know how this would play out in Tax Court. Oftentimes we see theory making sense on paper just to have it be viewed as an end-around by the court. However, if we can document the business purpose of the Family Management LLC as it pertains to its business to business relationship with the S corporation, then let’s document the heck out of it and deploy immediately. But please understand the risk. Even Forbes says Go for it, but then again, they aren’t going to pay your penalties and interest.
Conversely, there might be several situations where paying your children a salary from your S corporation continues to make a lot of sense. More in this and other fringe benefits in our chapter on tax deductions.
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